No Dice

With governments around the world finally attacking the global credit crisis in concert, the push is on to stop the global economy from tipping over into a protracted recession that could last for years.  

But there still exists a little known, mystifying reason why Wall Street has been leveled, why markets around the world have been shaken, why central bankers have taken to the barricades, and why the US government has been brought to a virtual standstill as it hashes out an historic rescue of Wall Street, a $700 bn bailout in the form of a mega-dumpster to buy the Street's Kryptonite paper, a taxpayer-funded trash compactor whose size has never before been seen in the history of finance.

The Heart of the Problem

The problem has been blamed for worsening the credit crisis, as it stands behind the record $650 bn in writedowns and losses taken by financial companies around the globe, a sum whose size surpasses the gross domestic product of at least 100 countries combined.

It's a problem I've been warning you about since last fall.

It's called mark-to-market accounting, the practice of pricetagging the value of mortgage bonds churned out during the housing bubble, bonds whose values now stand at pennies on the dollar, Kryptonite bonds strung in a drunken daisy paper chain now perambulating mindlessly around the globe, zapping hundreds of trillions of dollars out of investment portfolios.

Mark to market, meaning, companies must treat these bonds as if they were to sell them today and then pricetag what they could get for them accordingly. Companies must then book these losses on these bonds even if they did not sell them.

As the markets remain in a blackout for these subprime bonds, companies can't do mark to market accounting for them because there is no market to mark them too. This sounds like a bad Abbot and Costello movie.

And as the markets continue to bungee-cord around, as the magnetic gravity forces of this whipsawed market continue to torque prices of these bonds beyond recognition, the calculators auditors use to price them are wildly gyrating around as fast as a compass held over the North Pole.

Yes, understanding accounting can make you feel like you are bicycling through quicksand. But this rule is important--it's being partly blamed for the chaos worldwide. 

Warning Bells Rung

The accounting practice is partly why Wall Street has been demolished and why your taxpayer dollars are now heading toward a potential sinkhole, and again it's a practice I've been repeatedly warning you about since last fall when the credit crisis first picked up speed.

A sample of the blogs: "A New Rule Change That Could Hurt Taxpayers," "What's Really Rocking the Stock Market," "Where Do We Go From Here?," "Forget the Bailout: Here's a Better Way," "What Inning is the Great Credit Crunch In?", "The Reality Check That Bounced", and "What Congress Must Ask the Federal Clean-Up Crew."

No one really knows the value of these bonds and whether they are worth more or less than what the market says they are worth because the cash flow is or is not really there. As trust vanishes, the markets have now turned to the last triple-A rated borrower standing, the US government, to buy these damaged bonds.

The debate now is: Suspend mark to market accounting and hurt taxpayers, as the US government may overpay? Or are the rules so dangerously flawed that they have unwittingly and unnecessarily blown Wall Street to smithereens?

FASB Under Fire

The pressure is on, the cry is growing from places like the American Bankers Association for market watchdogs and accounting regulators, the Securities and Exchange Commission and the Financial Accounting Standards Board, to suspend mark to market accounting to give banks and financial companies some breathing room.

No dice. The FASB has stuck to its guns and said it would merely clarify, not suspend, the rule, called FAS 157, a clarification which hopefully will give companies a better sense of when they have to mark down their bad assets.

"So audit firms will continue to pressure the banks to permanently write down assets that have no credit-quality problems," economist Edward Yardeni notes, though the triple-A rated bonds that in reality were built on subprime loans have been axed in value.

And although Congress gave the SEC the authority to suspend mark-to-market accounting in the new legislation, the agency hasn't acted on it other than to have its chief economist also clarify FAS 157, Yardeni notes.

It is no small irony that the government's bailout plan essentially is an attempt to put a pricing floor under these bad securities that are now being priced and written down according to a governmental accounting body's rules.

How Crazy it Gets

The losses have caused banks to be in violation of their statutory capital requirements, forcing them to raise capital to plug balance sheet holes. The losses are also the reason why a growing number of financial companies have shut down, been forced into mergers, or been nationalized.

We saw very early on in the crisis how crazy the rule can get. Standard & Poor's, the US credit rating announced in March that it expected banks to write off $285 bn of mortgage assets. But then it quickly raised that estimate by $100 bn-odd, due to falling asset values and the rules.

That is just one of many revisions that has left banks, government regulators and investors so seriously disoriented, that widespread confusion has taken hold in the stock market, with unprecedented volatility, as the fear gauge, the VIX volatility index on options, broke through an unheard of 70 threshold, more than double the 30 limit reached last March when the markets turned suicidal after the government's rescue of Bear Stearns, which, with government help, was merged with JPMorgan Chase.

So, there is a bum's rush for the exits, there's gridlock there, as investors flee to the safety of government Treasurys, of nationalized banks (maybe their deposits will plug holes there), or they're standing on the sidelines not trading at all. 

Drill Down into the Problem

Wall Street and auditors have been using a potentially flawed index to find valuations for these bonds, such as the so-called "ABX" index, which tracks the cost of insuring mortgage-backed bonds against default.

The index has already been criticized by the Bank of International Settlements, the central bank of all central banks, the premier organization for central bankers around the world based in Basel, Switzerland, which warned last June that the writedowns may be overblown due to accounting rules used to book them (see blog "Are Wall Street's Writedowns Overstated?")

The indices, called the ABX  series, is run by Markit, a London-based company that sells financial data, portfolio valuation information and over-the-counter (OTC) derivatives processing.

Again Markit's ABX index is illiquid and is only about three years old. Trading in the first ABX index series started in January 2006. Each index consists of a group of equally weighted, static portfolios of CDSs based on 20 subprime MBS transactions.

The ABX Index is Unreliable

The ABX is a synthetic credit derivative index, or a basket of credit default swaps that are basically high-priced gambling bets on where investors think the direction of the underlying bonds backed by subprime mortgages are headed.

I know this is complicated, but bear with me, it's important. The swaps in the ABX are basically bets on the prices of the 20 supposedly most liquid (not saying much) subprime mortgage-backed bond deals. It's an understatement to say booking prices based on this index is accounting that is more art than science.

It's not just that the index was historically used to grab a quote, and not as a regulatory cudgel deployed by auditors.

Can an index based on values for just 20 bond deals legitimately be used for an asset class that is trillions of dollars in size? An index that historically undervalued the cash bonds it purportedly represents? An index now noted for its negative sentiment and one that is routinely used by short sellers to attack these securities?

An index, depending on how you look at it, that is tossing off wildly different ranges of losses for the financials, anywhere from $220 bn to $300 bn to $400 bn to $700 bn? An index that seemingly doesn't take into account that the underlying assets, the houses, still exist?

The ABX is essentially tossing off prices based on perceptions, the perception of traders who are looking at the credit rating agencies who are looking at the auditors who are looking at the banks who are looking at the traders. All locked into a claustrophobic graveyard spiral. All calamitous for stocks.

So it's either this dizzying turntable of bearish fears, or a distressed sale, that Holy Grail of the capitulation event Wall Street has been searching for, a washout that would finally tell the world what these bonds are really worth and would let investors put the crisis in the rearview mirror.

A slow dribble of mini-capitulations that has turned into investor water torture.

Central Bankers Criticize the Rule

Already, the report from the Bank of International Settlements has warned that ABX prices may not be representative of the total subprime universe, due to the indices' limited coverage of the overall market.

For instance, the BIS report notes that the subprime securities picked up by the concomitant subprime ABX index are valued at about $31 bn. But the 2004 to 2007 vintage subprime MBS volumes are estimated at around $600 bn in outstanding amounts, so each ABX index only represents some 5% of the overall universe on average.

The BIS notes that, when you drill down into the ABX, the ABX prices may not be representative because each index series covers only part of the capital structure of the 20 deals included in each index.

On top of that, the indices appear to misrepresent deals as being long term in nature, making the writedowns larger, when they are actually shorter in duration, which in turn should make the writedowns lower, the BIS report explains.

Devastating Consequences

That has had devastating implications for the banks. Over the last year, the ABX has tumbled: the implied prices for some AAA instruments are now nickels on the dollar.

And even if Wall Street buys up the full $700 bn in mortgage bonds out there, can we be sure that investors will start buying these bonds until they have a real sense of what clearing prices should be?

Merrill Lynch, for example, just a couple of quarters back told the world a portfolio of bonds was worth more than 30 cents on the dollar, but within days then sold a portfolio of these distressed bonds at 22 cents on the dollar to vulture fund Lone Star Capital-and since Merrill financed 75% of Lone Star's purchase here, Lone Star effectively is saying that, to it, the bonds are only worth 6 cents on the dollar.

Size of the Remaining Writedowns?

Again, under new US accounting rules that took effect only last year, publicly traded US companies must value their assets at market prices and include them in certain buckets in their financials.

The rules set up three buckets to hold problem assets. The Level 1 bucket holds the assets that can more easily be sold in the markets.

Those assets not easily sold and valued based on partial market data by using valuation models get stuck in the Level 2 bucket.

If there is no market available, the assets are Level 3, and may be valued based on the best guesses of management. Meaning, these assets are poison, Kryptonite, so they are valued based upon what's called marked-to-myth or mark-to-make-believe accounting.

Economist Yardeni and his squad plowed through the quarterlies of the S&P 500 Financials to find out more about these assets. What they found should send a chill down your spine:

* Among the eight large commercial and investment banks that have been reporting this information since Q3-2007, over the past four quarters, Level 3 totaled $461 bn (Q3-2007), $485 bn (Q4-2007), $600 bn (Q1-2008) and $612 bn (Q2-2008).

* Level 2 totaled $4.3 tn (Q3-2007), $4.5 tn (Q4-2007), $6 tn (Q1-2008) and $5.5 tn (Q2-2008). "These numbers suggest that there may be plenty more kitchen sinks that will weigh on earnings for the large banks during the second half of this year," Yardeni warns.

* What about Level 1 for the big 8 banks? "Unbelievably, these are tiny compared to Level 2 and aren't that much bigger than Level 3," Yardeni says. Level 1 totaled $1.1 tn (Q3-2007), $1.1 tn (Q4-2007), $1 tn (Q1-2008) and $956 bn (Q2-2008).

There's more, Yardeni notes. I can't deliver this information any better than Yardeni did, this is straight from his report - again, his information, and the analysis collected and delivered by his team, is as vital as oxygen to investors.

Yardeni has noted that at the time of its collapse, Lehman Brothers had only $32.4 bn of Level 3 assets, far behind Goldman's $58.8 bn and Morgan Stanley's $57.1 bn.

But Lehman on its own was in dire straits. Its Level 3 assets constituted 23% of all of its financial instruments - the same percentage as much-larger Morgan Stanley and far higher than Goldman Sachs, for which Level 3 assets account for only 18% of its total financial instruments.

However, Yardeni says: "Compare those Level 3 assets as a percentage of tangible common equity, which is a metric that measures how much equity is available to stockholders.

Lehman's Level 3 assets were 146% of its tangible common equity - less than Goldman, where it is 162%, but far more than Merrill Lynch, whose recent fire sale of collateralized debt obligations (CDOs) to Lone Star Capital dropped its percentage down to just 48%.

Where is Housing Headed?

We are now just about 20% down from the peak in house prices reached in the summer of 2006, as measured by the widely followed housing index, the Standard & Poors Case/Shiller index.

The futures market is pricing in peak-to-trough declines in home prices of 33%, an estimated drop that would put homeownership prices back to 2002 and 2003 levels, when homeownership rates stood at 68%.

But that 33% decline would only bring the markets back to levels seen at a time when the mortgage securitization engines were still gunning, pumping out dirt-cheap mortgages on terms borrowers demanded, boosting house prices.

The Banks' Off-base Assumptions

However, Meredith Whitney, top bank analyst at Oppenheimer Equity Research, has already warned that banks are using way too rosy assumptions about house prices, which means more mark-to-market writedowns could be forthcoming.

For instance, Whitney says Bank of America (BAC) and JPMorgan Chase (JPM), through 2008, are using 25% to 30% and 24% peak-to-trough declines, respectively. Citigroup is using just a 23% peak-to-trough assumption.

Cause for Optimism?

But in a paper presented before the Brookings Institution in Washington, D.C., Wellesley College economist Karl Case, the Case in the Standard & Poors Case/Shiller index, argues that there is cause for optimism. He notes that of the 20 metropolitan areas covered by the Case/Shiller index, nine have shown prices slightly improving in recent months.

Case also says that the relationship between incomes and home prices has neared a level seen at the end of past housing slumps.

How far home prices fall matters greatly for financial institutions, Goldman Sachs economist Jan Hatzius argued in another paper presented at Brookings. If the Case/Shiller index stays at its June level, total mortgage losses will come to $473 bn, Hatzius estimates. He estimates that a further 10% decline in home prices would lead to losses of $636 bn and a 20% decline would lead to $868 bn in losses.

Loophole Dangerous to Taxpayers in the Rescue Bill

Check out this sentence I've highlighted in italics in section 101 of the new bill, entitled "purchases of troubled assets"-it could also mean even higher costs to taxpayers:   

"(e) PREVENTING UNJUST ENRICHMENT. In making purchases under the authority of this Act, the Secretary shall take such steps as may be necessary to prevent unjust enrichment of financial institutions participating in a program established under this section, including by preventing the sale of a troubled asset to the Secretary at a higher price than what the seller paid to purchase the asset. This subsection does not apply to troubled assets acquired in a merger or acquisition, or a purchase of assets from a financial institution in Conservatorship or receivership, or that has initiated bankruptcy proceedings under title 11, United States Code."

Quite the loophole-acquirers can use the rule to mark up the value of these bonds in a merger, and then dump them on the US taxpayer.

The section "probably indicates that JPMorgan Chase can sell the troubled assets of WaMu to the US government and make windfall profits," notes market analyst Richard Suttmeier. "Other future deals as well. That is a direct bailout of Wall Street on the back of taxpayers."